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Wednesday, July 30, 2014

Now that the revised 2013 GDP numbers are out it is worth revisiting the debate surrounding the 'Great Experiment' of 2013. It started with Mike Konczal firing this opening salvo at Market Monetarists in early 2013:

In late 2011, the economist David Beckworth and the writer Ramesh Ponnuru wrote an editorial
in the New Republic on how “both liberals and conservatives are wrong
about how to fix the economy.” How were they wrong? Conservatives were
wrong because, contrary to common belief on the right, the Federal
Reserve wasn’t in fact doing enough to boost the economy.
Liberals, however, were wrong in opposing austerity and calling for
more fiscal stimulus in the form of stimulus spending or temporary tax
cuts.

In Beckworth and Ponnuru’s view, the Federal Reserve still had
plenty of room to boost the economy. Not only would fiscal tightening be
good over the long haul, but it would force the Fed to act. And they
argued that as long as the Fed is working to offset austerity, the
country “won’t suffer from spending cuts.

We rarely get to see a major, nationwide economic experiment at work,
but so far 2013 has been one of those experiments -- specifically, an
experiment to try and do exactly what Beckworth and Ponnuru proposed. If
you look at macroeconomic policy since last fall, there have been two
big moves. The Federal Reserve has committed to much bolder action in
adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal
austerity. Was the Fed action enough to offset the contraction?

Paul Krugman liked Konczal's idea of 2013 being an experiment to test ideas and chimed in:

On the right are the market monetarists like Scott Sumner and David
Beckworth, who insist that the Fed could solve the slump if it wanted
to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out,
we are in effect getting a test of the market monetarist view right
now, with the Fed having adopted more expansionary policies even as
fiscal policy tightens.

Some observers predicted that this fiscal tightening might costs as
many as 700,000 jobs. Market monetarists like Scott Sumner and myself
were more optimistic. I agreed at the time
that this development would provide a kind of natural experiment to test whether monetary policy could offset fiscal at the zero lower bound (ZLB), but
cautioned that it was only a test of how effective QE3 would be against
the sequester. It was not a test of whether a NGDP level target, my ideal, could restore full employment at the ZLB. Scott Sumner made a similar guarded reply. Still, the 'Great Experiment' was on and thanks to Konczal and Krugman our views were
to be publicly put to the test in 2013.

An important question that came up in this experiment was how
best to measure fiscal austerity. It is not that easy since one has to control for the influence of the business cycle. Fortunately, Paul Krugman explained how to do it:

Now, measuring austerity is tricky. You can’t just use budget
surpluses or deficits, because these are affected by the state of the
economy. You can — and I often have — use “cyclically adjusted” budget
balances, which are supposed to take account of this effect. This is
better; however, these numbers depend on estimates of potential output,
which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates

This IMF measure includes all levels of
government--local, state, and federal--when calculating the government
balances. It is a thorough measure. Below is a figure of it based on the latest IMF Fiscal Monitor. It shows that the cyclically-adjusted deficit as a percent of potential GDP started getting smaller in 2010. Structural fiscal policy, in other words, was contracting well before 2013.

According to Konczal and Krugman, this tightening of fiscal policy should slow down aggregate spending. So did it? The figure below shows total dollar spending in the United States as measured by nominal gross output (it includes all transactions, not just the final ones used in GDP). It shows no signs of a spending slowdown since fiscal tightening started in 2010. And none in 2013 either, the year of the 'Great Experiment.' Similar results are fond by looking at nominal GDP.

The newly revised numbers for GDP in 2013 further confirm these observations. They came in stronger than previously reported. As Scott Sumner notes,these new numbers scream "fail" for the Keynesian view. Monetary policy was easily able to offset the 2013 fiscal austerity despite the ZLB.

So what are the lessons? First, this 'Great Experiment' of 2013 revealed the potential of monetary policy even at the ZLB. It suggests the Fed could have done more over the past five years to restore full employment. Alas, it did not!

Second, this experiment also suggests that measuring the fiscal multiplier can be tricky. In this case, someone might think the multiplier was negative in 2013 since tightening fiscal policy was followed by sustained economic growth. Along the same lines, the true impact of the President Obama's American
Recovery and Reinvestment Act of 2009 is hard to measure since had it not happened it is likely the Fed would have done more.

Third, the economics blogosphere is a great place to propose ideas and begin hashing them out. Mike Konczal's keen observation that 2013 was providing a natural experiment of sorts and the discussion that it created is a great example. I have learned a lot on many issues and am grateful for this medium.

Monday, July 28, 2014

One hundred years ago today World War I (WWI) began. On this anniversary there has been a lot of discussion about the war and its implications for the century that followed. Today, as I traveled, I got to listen to one such discussion on the NPR program, On Point. The host, Tom Ashbrook, interviewed several historians and a commentator about the war. It was a really interesting show and I learned a lot, like how the problems in Middle East and Ukraine can be traced in part to the boundaries that were drawn after the war. I could not have asked for a better traveling partner.

There was, however, an important point I did not hear discussed on the show and could not find on other commentaries commemorating WWI: the important legacy this war had on the international monetary system. WWI shattered the classical gold standard of 1870-1914, which had worked relatively well, and replaced it with an incredibly flawed one that is attributedby many to the severity and global reach of the Great Depression in the 1930s. And the Great Depression, according to some historians, was the key catalyst that brought the Nazis to power. Here, for example, is Barry Eichengreen and Peter Temin:

Rivers of ink have been spilled over the causes of the Nazi rise to power. Studies have championed and refuted competing hypotheses about the relationship between the German economy and the votes for the Nazi party. At some level, however, there cannot be any doubt that the Nazis were the party of the Depression. They were a fringe group in the 1920s and grew to electoral prominence only in 1930 when economic conditions deteriorated. They gained even more seats in the Reichstag in the first election of 1932, but lost seats in the second election later that year as economic conditions appeared to improve. Had that improvement come earlier, a new study using panel data shows clearly that the Nazi vote would have been smaller.18 We do not have a model of the political process that tells us how weak the electoral support for the Nazis would have had to be to significantly affect the political maneuvering among the leaders of the Weimar Republic. But almost any model would say that better economic conditions would have decreased political support for the Nazis and therefore the probability that Hindenburg would have asked Hitler to be chancellor.

So far all the problems WWI created, the flawed interwar gold standard was probably one of the the more important ones. It led to the Great Depression which, in turn, guaranteed the rise of the Nazis and another world war. The big lesson, then, is getting the international monetary system right matters a lot.

Update: Francesco Lenzi shares this interesting picture on twitter. It shows that the Great Depression, not the Weimar hyperinflation, was behind Hitler's rise.

Thursday, July 24, 2014

The Fed's QE3 program is scheduled to end later this year. This will bring to a close the Fed's five year experiment with QE programs. They have been incredibly controversial, especially among those who believe these programs enabled the federal government to run large budget deficits. Those holding this view typically make one of two claims. First, the large scale asset purchases (LSAPs) done under QE meant the federal government had a guaranteed purchaser of its securities. Second, the QE programs kept the federal government's financing charges inordinately low. So are these claims correct? Let's look back at the data to find out.

Consider first the Fed's share of marketable U.S. treasuries as seen in the figure below. The Fed's treasury holdings have gone from just under $0.8 trillion in late 2007 to about $2.39 trillion as of June, 2014. Over the same time, other holders of treasuries have gone from roughly $4.4 trillion to about $10.2 trillion.

The next figure shows these same two groups in terms of cumulative change in their holdings since the beginning of 2007. Note that the Fed actually sold off a sizable portion of its treasury holdings during 2008 just as the government deficits started growing.

In total, the Fed has acquired about $1.6 trillion of treasuries compared to $5.8 trillion acquired by the other holders. The largest run up in U.S. debt history, then, was mostly funded by foreigners, financial intermediaries, and individual investors. It was not the Fed.

Now it is true that under QE3 the Fed did start to buy up more long-term treasuries, so it could still be guilty of distorting long-term yields. The figure below shows the composition of its holdings relative to the total amount (not including TIPs) as of June, 2014:

So has the Fed been 'artificially' pushing long-term treasury yields? Even Fed officials claim that QE works by lowering long-term interest rates. Well that was the theory and these are the facts: long-term treasury yields tended to rise during periods of treasury purchases under QE. If anything, then, QE programs raised long-term financing costs for the government.

One way
to explain this outcome is that the QE programs actually raised expected
economic growth and that pushed up treasury yields. Okay, says the
skeptic, maybe the Fed's QE programs raised the expected path of
short-term interest rates by raising expected economic growth. But
surely the Fed's large scale asset purchases (LSAPs) lowered the term
premium portion of long-term yields. That was, after all, the deeper theory behind the claims that QE would make long-term interest rates fall. Even if interest rates overall went up, the term premium must have fallen. Using the Adrian, Crump, Moench (2014) and Kim and Wright (2005) data, we see the opposite actually occurred. Term premiums tended to rise during QE programs.

It
is particularly interesting to see the term premium fall so much
between QE2 and QE3. It is as if the term premium needed QE to stay propped up. Here is one possible explanation. The QE programs increased
the economic outlook and that, in turn, reduced the risk premium on
other assets. Investors, therefore, were more willing to hold other
higher-yielding assets and this meant they had to be compensated more to
hold the low-yielding treasuries. Likewise, between QE programs, risk premiums on other assets rose and caused investors to flock back to treasuries. This migration caused the term premium to fall between QEs. In any event, this data indicates the
Fed failed at lowering the term premium.

So claims of the Fed enabling the large budget deficit are not supported in the data. An alternative explanation that is that the overall increased appetite for safe assets over the past five years was the true enabler. And here is where I think the Fed is responsible. By failing to restore full employment to the economy, the Fed has allowed risk premiums to stay elevated and interest rates on safe assets to stay depressed. In fact, the 10-year treasury real risk-free interest rate (the nominal treasury yield minus expected inflation minus the term premium) closely tracks the the CBO's output gap as seen below:

Now one could conclude from this that the QE programs did not make that much difference. I disagree. The evidence above suggest the Fed at least put a floor under long-term interest rates (and by implication a floor under the economy) with its QE programs. To know for sure how different the economy would have been in the absence of QE one needs to do a counterfactual. Here is my modest attempt at one and here is one by Barry Ritholtz. In both cases the economy would been a lot worse off without it.

So goodbye QE. It was good knowing you.

PS. Yes, the Fed's QE programs were flawed. They were very ad-hoc and designed in a way that would prevent them from restoring full employment. But again, the alternative may have been far worse.

Wednesday, July 23, 2014

Apparently, it is open season on market monetarists. The red dots you see on our chest are from the laser scopes on the new keynesian guns of Tony Yates, Simon Wren-Lewis, and Paul Krugman. These individuals have been firing away with their critiques of market monetarism. Scott Sumner and Nick Rowe have already responded to many of them. Here I want to focus on what I view as one of their better criticisms: even if we are correct that monetary policy alone can end the slump, central banks have not shown themselves willing to do so. So why argue for them to do more? Here is Simon Wren-Lewis making this point:

MM agrees that fiscal stimulus will work unless it is actively counteracted by monetary policy. Nick says we can't always rely on fiscal policymakers being able and willing to do the right thing. But since at least 2011 we have not been able to rely on monetary policymakers in the Eurozone to do either the right thing, or consistently the wrong thing.

I think this is a fair point. The Fed failed to unload both barrels of its gun--by signalling its monetary injections were to be temporary--over the past five years while the ECB actually tightened monetary policy in 2011. Given this reality, the new keynesians want to know why not use fiscal policy? They contend that if monetary policy is too timid or tight, surely fiscal policy could make up for its shortcomings.

My view, and one that I believe is shared by most market monetarists, is that fiscal policy will not matter much as long as these two central banks are committed to their inflation targets. Any surge in aggregate demand created by fiscal policy would be sterilized by the central bank if it pushed inflation too high. And by all accounts both the Fed and ECB take their low inflation targets seriously.

In the case of the Fed, it seems to be aiming for core PCE inflation to fall between 1% and 2%. Any fiscal stimulus that pushed inflation outside this corridor would probably be offset. That is why I argued that had there been no American
Recovery and Reinvestment Act of 2009 the Fed probably would have taken more expansionary steps back in 2009. It also why the Fed offset the effects of fiscal austerity of 2013. The Fed, then, appears to be doing just enough to maintain its corridor inflation target, which is nowhere near enough to close the output gap. Fiscal policy is bound to be offset in such an environment.

So what is needed is a better way to do macroeconomic policy. One that would allow monetary policy to close the output gap and, in its absence, allow fiscal policy to do the same. I have a proposal does just that. It is a two-tiered approach to NGDP level targeting:

First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap... [I]f the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow [say due to central bank incompetence] and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

The nice thing about this proposal is that it provides insurance against central bank
incompetence. Scott Sumner initially did not like this proposal, but as he loves to say the fiscal multiplier is nothing
more than an estimate of central bank incompetence. That is, the fiscal
multiplier is large only when the central banks fail to properly
stabilize aggregate demand. Helicopter drops are fiscal policy and
in this proposal they would be applied only when the Fed failed to
stabilize demand. Therefore, it is a perfect fit. Employ fiscal policy
only when it packs a punch and do so in a manner to preserve a NGDP
level target. This should make both market monetarists and new keynesians happy.

Note that this approach with its NGDP level targeting implies a commitment to permanent monetary injections, if needed. It, therefore, holds up against the critiques of helicopter drops that Paul Krugman, Scott Sumner, myself, and others have raised. It would also provide a more systematic approach to monetary policy, a big improvement over the current ad-hoc approach of the Federal Reserve. This increased certainty by itself would be a boon to the economy. Finally, it would eliminate the need for the politically-charged fiscal stimulus spending programs. There is much to like about this proposal on both the political left and right.

Tuesday, July 15, 2014

I have an new article in the Washington Post where I make the case against secular stagnation. My argument is based on three observations. The details of these arguments and evidence for them are spelled out in the piece, but here is a quick summary.

First, the prima-facie evidence most secular stagnation advocates point to is misleading. They see the long-decline of real interest rates since the early 1980s as supporting their view. Their real interest rate measures, however, do not account for a trend decline in the risk premium. Once that is done there is no downward trend in real interest rates. And this measure--the 10-year real risk-free interest rate--is the one at the heart of the secular stagnation story.

This long-run measure of the natural interest rate is currently negative, but only because of the current slump--its deviations tracks the CBO's output gap--and appears to be simply deviating around a roughly 2% trend. Based on this evidence, there is no reason to believe it has permanently turned negative.

Second, claims about a trend decline in technical innovation and productivity growth are overstated. It is getting increasingly hard to measure economic activity with GDP in an increasingly digitized economy. This means productivity gets under measured. Moreover, there is reason to be believe we are on the cusp of a rapid growth spurt as noted by Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. If so, the return to capital will rise and so will investment demand This should put upward pressure on the natural interest rate.

Third, the demographic outlook is not so dire. Baby boomers are no longer the largest U.S. cohort and around the globe the outlook for the prime-age working population is improving. This too implies a higher return to capital, more investment spending, and upward pressure on the natural interest rate.

One thing I did not get to fully explain in the article is why the growth of productivity and the labor force should affect the natural interest rate. To do this, we need to first recognize there was a trend and cyclical component to the 10-year real risk-free interest rate. This is equivalent to saying there is a long-term and short-term natural interest rate, with the latter gravitating around the former. So we need to distinguish how these different components are determined. Also, I left out a third determinant of the natural interest rate: household time preferences. My assumption in the article is that this part is relatively steady and all the interesting developments come from changes in productivity and labor force growth.

So with all that said, below is an explanation of long-term and short-term natural interest rate determinants. It is drawn from an earlier post:

[T]he long-term nominal natural interest rate is determined by trend
changes in the expected productivity growth rate, the population growth
rate, and household time preferences... Productivity matters because it affects the expected
return to capital and expected household income. Faster productivity
growth, for example, translates into a higher expected return on capital
and higher expected household incomes. In turn, these developments
should lead to less saving/more borrowing by firms and households and
put upward pressure on the natural interest rate. The opposite would
happen with slower productivity growth. Population growth matters
because it too affects the expected return to capital. More people means
more workers and output per unit of capital. For example, the opening
up of China and India's labor supply to the global economy, meant a
higher expected return to the global stock of capital over the past
decade. That should put upward pressure on interest rates and vice
versa. Finally, for a given level of expected income, a change in
households time preferences means a change in their desire for present
consumption over future consumption. This, in turn, affects households'
decision to save and borrow. If households, say, start living more for
the moment there would be less saving, more borrowing, and upward
pressure on the natural interest rate.

Some like Paul Krugman and Larry Summers
believe these determinants have changed enough such that the long-term
nominal natural interest rate has been negative. I am not convinced and hope to explain
why in a subsequent post (if you cannot wait, see my views in this twitter discussion).
In my view, then, the important question is whether the short-run
nominal natural interest rate has been negative since the crisis
started.

So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand
shocks that create temporarydeviations of the economy above or below its full-employment level (i.e. output gaps). For example, a large
negative aggregate demand shock that temporarily weakens the economy will put
downward pressure on interest rates. This happens because firms do less
investment spending and therefore less borrowing in anticipation of lower future profits. It also
happens because households, particularly credit and liquidity
constrained ones, save more and borrow less in anticipation of lower
future incomes. In short, aggregate demand shocks that create output
gaps will also push the short-run nominal natural interest rate in a procyclical
direction. This is a natural process that allows the economy to heal
itself. What is not natural is when interest rates are prevented from
fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem.

I hope that helps. Be sure to read the article at the Washingont Post.

Monday, July 14, 2014

Many observers claim the Fed has been keeping interest rates artificially low over the past five years. They contend this low-interest rate policy is creating financial instability via an unnatural reach for yield and harming folks who depend on fixed income. They want to see the Fed raise interest rates now.

Paul Krugman has recentlytakeniton himself to contest this view. His reply is that interest rates can only be artificially low if they are below the natural interest rate level, but he sees most evidence pointing to the opposite case. Interest rates appear to have been higher than the natural interest rate level and explain the persistence of the slump. This situation arises because of the zero lower bound as explained here. Accordingly, monetary policy has been effectively tight.

I agree with Krugman that when thinking about an interest-rate targeting central bank one should look at the gap between the actual and natural interest rate to determine the stance of monetary policy. Otherwise, one could conclude monteary policy was tight in the 1970s and loose in the 1930s. No one would make that argument. So the interest rate gap makes more sense.

But there is a big problem with this approach. There is hardly any data on the natural interest rate. The Fed provides none and there are only a few private estimates of it. This debate will never be settled without some consensus measure of the natural interest rate and currently there is none.

As I argued before, this should be a scandal for an interest-rate targeting central bank. It would be akin to a central that targets the M2 money supply but chooses not to publish M2. Yes, the natural interest rate is trickier to measure than the money supply, but the Fed already estimates its as seen in this figure from a 2005 FOMC meeting. At a minimum, the Fed should be reporting its estimates for the natural interest rate across the entire term structure of interest rates. It would go a long way in ending the confusing over the stance of monetary policy and would keep the Fed more accountable for its actions.

That's the minimum. It would be even better if the Fed started regularly surveying market participants, forecasters, and other interested parties on their estimates of the natural interest rates across the term structure. Then report the distributions of these estimates along side the Fed's own estimates. The Fed has the resources to do this, so why not? All this information would be bring much clarity to the big debate on natural interest rates.

Until these changes happen, I look forward to more confused discussion about the stance of monetary policy. Adopting these policies would be a great way for Janet Yellen to leave her mark at the Fed.

PS. Yes, this is a pragmatic proposal. I actually would like the Fed to switch to NGDP level targeting and stop using short-term interest rates as an intermediate target. Rather, I would have the Fed look to a NGDP futures contract as its intermediate target and adjust the monetary base accordingly. There is also a place for Divisa monetary aggregates as indicator variables, as shown by Michael Belongia and Peter Ireland. Had observers in this debate been looking at them, they would see that monetary policy has been tight.

Friday, July 11, 2014

I have a new policy paper that argues inflation targeting has passed its expiration date. Here is the title and abstract:

Inflation Targeting: A Monetary Policy Regime Whose Time Has Come and Gone
Inflation targeting emerged in the early 1990s and soon became the dominant monetary-policy regime. It provided a much-needed nominal anchor that had been missing since the collapse of the Bretton Woods system. Its arrival coincided with a rise in macroeconomic stability for numerous countries, and this led many observers to conclude that it is the best way to do monetary policy. Some studies show, however, that inflation targeting got lucky. It is a monetary regime that has a hard time dealing with large supply shocks, and its arrival occurred during a period when they were small. Since this time, supply shocks have become larger, and inflation targeting has struggled to cope with them. Moreover, the recent crisis suggests it has also has a tough time dealing with large demand shocks, and it may even contribute to financial instability. Inflation targeting, therefore, is not a robust monetary-policy regime, and it needs to be replaced.

In the paper I go through the history of inflation targeting and tie together together several existing critiques of it to show that it no longer is an adequate way to do monetary policy. One critique of it that is topical and should be of interest to readers is my discussion of how inflation targeting can contribute to financial instability. A number of observers, including prominent economists like William White and Lawrence Christiano, Roberto Motto, and Massimo Rostagno, have found that even flexible inflation targeting has a propensity to give rise to the buildup of financial imbalances and exacerbate boom-bust cycles. I draw upon their work and provide empirical evidence supporting their claims.

I also note the failure of inflation targeting to close the output gap in the United States and the Eurozone as further evidence of its limited ability. And for those who like a more rules-based approach to monetary policy I discuss how the evolution of inflation targeting into flexible inflation targeting opens the door for more judgement calls and opportunities for bad calls as monetary policy is executed in real time.

Since most of the paper covers the problems with inflation targeting--there is a brief section at the end on what should replace it--I thought I would plug here another recent article I coauthored with Ramesh Ponnuru that provides a nice follow up. It shows, based on what happened in recent crisis, what should be the next step in the evolution of monetary policy:

A global economic crisis may be painful, but it can provide some useful lessons. Countries recovered from the great Depression in the order that they exited the gold standard of the time, which is a major reason most economists no longer favor that monetary regime. The turmoil of the last few years has followed a pattern as well: The more a country’s central bank has done to keep nominal spending growing at a steady rate, the better that country has done. This international experience adds to an already-strongtheoretical case for keeping nominal spending—the total amount of money spent in an economy—on a predictable path

[...]

Targeting nominal spending avoids these pitfalls [facing inflation targeting]. If the Fed were trying to keep total dollar spending growing at a 5 percent rate each year, for example, it would not need to loosen or tighten in response to supply shocks. Such shocks would alter only the composition of spending, with positive [negative] ones translating into more [less] goods and services at lower prices. To stay on target, the central bank need respond only to shifts in the demand for money balances. It has to increase the money supply when people are more inclined to hold money balances—when, for example, they are scared of economic trouble and want liquid assets—and decrease the money supply when they are rapidly spending money. To put it another way, the central bank must decrease the money supply when money is circulating quickly and increase it when its turnover or velocity is low. And the more markets expect spending to stay on its target path, the more stable velocity should be in the first place.

We provided several figures that make this point. First, here are the paths of total money spending relative to trend for Israel, Australia, the United States, and the Eurzone (the U.S. trend path is adjusteded to reflect CBO's estimates of full-employment NGDP):

As the above figure shows, Israel and Australia roughly stayed on their trend paths while the United States and the Eurozone did not. These developments can be seen in terms of money supply and money velocity deviations from their trends. In order for total money spending to stay on path, monetary policy has to adjust its stance so that changes in the money supply and money velocity offset each other. As seen below, all of these countries were effectively doing that prior to crisis, but only Israel and Australia continued doing so during the crisis. The grey bars show where the United States and the Eurozone did not do the offsets.

Both Israel and Australia are great success stories of what monetary policy can do even in a severe crisis. Israel's performance, in particular, is instructive as seen here. And the closer a central bank kept its total money spending to its trend path the less unemployment it had during and after the crisis:

So yes, it is time for the Fed to move beyond inflation targeting and officially do what Israel and Australia have unofficially have been doing: stabilizing the growth path of total money spending. This is the same thing as targeting nominal GDP.

PS. Josh Hendrickson has a nice paper that shows an welfare-maximizing central bank could aim to minimize the loss function of money supply and money velocity deviations. If this approach were more commonly used--as oppossed to using a loss function of output and inflation deviations--it would put focus back on what central banks at their core do: stabilize total money spending. And it may have helped avoid the problems seen in the second figure above.

Wednesday, July 9, 2014

Rather, there is a 2% upper bound to the Fed's inflation target. This is an argument that Ryan Avent, Matt Yglesias, Paul Krugman, and others have been making for some time. I am sympathetic to this view and have made the case that the Fed has been effectively targeting a core PCE inflation corridor of 1% to 2% over the past five years. The evidence continues to mount in favor of this view.

First, consider the timing of the Fed's QE programs and changes in the core PCE inflation
rate as seen below. The figure suggests that the FOMC iniatiates
QE programs when core inflation is under 2% and has been falling for at least six months. It also indicates the FOMC tends to end QE programs when core inflation is above 1% and has been rising for at least six months. That ending of QE3 in October later this year follows this pattern.

Reinforcing this point, the Fed's purchases of treasuries since the crisis started is correlated with changes in core PCE inflation. Specifically, changes in the Fed's holdings of treasuries as percent of all treasuries can explain almost half of the variation in core PCE inflation since 2007 as seen below:

Second, consider the central tendency ranges of inflation forecasts
provided by members of the FOMC. This information can be found in the 'projection' material. These forecasts are consistent with the observed core PCE inflation data highlighted above. They consistently show 2% as an upper bound.

Though it gets clearer with longer forecast horizons, the 2% upper bound can be seen in the current, one-year, and two-year inflation FOMC forecasts shown in the figures blow. A 1% lower bound is most evident in the current year forecast, but slowly gets higher at longer forecast horizons. (Note: not every
FOMC meeting has projection materials, but for every meeting that does
provide them they are lined up chronologically in the figures.)

FOMC members are predicting inflation no higher than 2% even two years out.
Since the FOMC has meaningful influence on inflation this far out, this
forecast reflects FOMC members' beliefs about current and expected Fed policy. They see the Fed doing just enough to keep core PCE inflation under 2%. The actual core PCE inflation evidence provided above suggests the Fed is doing just that.

The June FOMC minutes were released today. One interesting development we learned from it is that some FOMC members are becoming concerned that the Fed may be slowly taking on more and more financial intermediation activities that traditionally have been provided by banks. In the limit, this would amount to a nationalization of banking. The Fed would become the only bank and your local bank, if it were still around, would be its branch office. All money would be Fed liabilities and there would no longer be a distinction between inside and outside money. In other words, the Fed would directly control the money supply.1 Money supply targeting might actually become vogue again!

We are a long way from that point, but some FOMC members are concerned we are on that path to it. This concern centers around the Fed's new overnight reverse repurchase agreement program (ON RRP). It provides a means for the Fed to temporarily return some its treasury holdings to a safe asset-scarce market and to influence short-term interest rates. It also provides a super safe alternative to institutional investors who normally park their funds in the money market. And that is where it could be problematic. Here is the FOMC:

In addition, a number of participants noted that a relatively
large ON RRP facility had the potential to expand the Federal Reserve’s
role in financial intermediation and reshape the financial industry in
ways that were difficult to anticipate.

The
Federal Reserve Bank of New York has emerged as the single largest
player in an important segment of the short-term lending market that was
at the epicentre of the financial crisis.The Fed’s decision to quadruple its trading with
government money market funds in the repurchase or “repo market” is a
sign that the central bank is now engaging more directly with the shadow banking system at the expense of large Wall Street banks... Armed with a balance sheet of $4.3tn of bonds purchased during
quantitative easing, the Fed is using what it calls its reverse repo
programme, or RRP, to trade with money funds at a time when tough new
regulatory standards have made such borrowing less attractive for the
banks. Rather than lending to the banks, money market funds have sharply boosted their dealings with the US central bank.

[...]

Bill Dudley, New York Fed president, warned
last month that if use of the repo facility were to grow too quickly it
might “result in a large amount of disintermediation out of banks
through money market funds and other financial intermediaries into the
facility. This could encourage further enlargement of the shadow banking
system.” Without a cap on use of repo with the Fed, investors who ordinarily
lend to banks could instead flock to the central bank in times of market
stress, exacerbating a flight from funding of banks, he warned.

Now, as noted by Izabella Kaminski, if this specific concern actually happens it would only usurp the financial intermediation services provided to institutional investors. There would still be the retail investor market to conquer. She says this second step could occur if the Fed started issuing e-money for retail customers. That may be a way off, but Kaminski believes it is coming. And she believes the June FOMC minutes indicate the members sees it coming too. Here is Kaminski:

What the Fed seems to be acknowledging is that if its reverse repo programme (RRP) proves too popular it could end up undermining the business of conventional deposit-taking banks. In other words, the Fed is prepping us for the idea that this is the route by which the central bank could become a universal banker... The thing to note, however, is the language and tone being used to
communicate these ideas. The message is clearly that the Fed is mindful
and fearful of becoming a universal banker and that this is not at all
something that it wants.

If all of this comes to fruition I will be worried. The Fed is already a monopoly producer of the unit of account and this would make it a monopoly producer of the medium of exchange too. Monopolies have less incentive and less ability to nimbly respond to changing market conditions. In this case, that means changes in money demand. Unless technology changes so that the Fed is capable of knowing in real time region-specific changes in money demand, it will be applying a one-size-fits-all monetary policy that will intensify regional economic differences. We might begin to think twice about the United States as an optimal currency area. But hey, at least we will all have our own Fed checking accounts!

1Tomas Hirst and Frances Coppola note that if the Fed does become a universal bank there will still be some private financial intermediation, even if on the margin. So it would not have 100% direct control of the money supply, but close.

Friday, July 4, 2014

This is a great question to consider as we celebrate Independence Day here in the United States. It is also a great question for Europeans who have learned the hard way that the Eurozone is not an optimal currency area. Fortunately, economic historian Hugh Rockoff has already worked on this question and concluded it took only 150 years. Yep, that means the Eurozone project needs another 135 years or so before it works. I can hardly wait.

In 1788, Congress was given the exclusive right to "coin
money" and "regulate the value thereof." Since then, Americans
have spent and invested within the immense area of this country
without ever having to worry about different exchange rates. The
only exception to the monetary union occurred during the Civil War,
when the nation was divided into three monetary regions.

In How Long Did It Take the United States to Become an
Optimal Currency Area?
(NBER Working Paper No. H124),
NBER Research Associate Hugh Rockoff explores the costs and
benefits of the monetary union. He notes that "the survival of the U.S. monetary
union is at best muted evidence that the net effects have been positive."

The incentive for a region to join a monetary union is the
minimizing of transaction costs. But the costs of uniting include
giving up the exchange rate and changes in the money stock as
policy tools. Whether a specific area composes an optimal currency
area, or whether it would be better off as a segment of a larger
monetary union, depends on the net sum of the costs and benefits.
During the first 150 years of the U.S. monetary union, regional battles
over monetary policy and institutions were widespread. Simply put,
what was beneficial monetary policy for one region was not
necessarily beneficial for another.

Rockoff finds numerous examples of regional shocks magnified
by monetary reactions. The typical scenario involves a shock in
financial or agricultural markets which would hit one region
particularly hard. The banking system in the region would lose
reserves resulting in a monetary contraction. A political battle would
often erupt, and the regions that had experienced the contraction
would demand a reform of the monetary system. The resulting
uncertainty about the future of existing monetary institutions would
further intensify the initial contraction.

So, how long did it take the United States to become an optimal
currency area? Rockoff concludes that a reasonable minimum may
be 150 years. It was not until the 1930s that all regions in the
country could be said to be components of a single optimal currency
area, the United States. Thus for a country debating whether to join a
monetary union, it would be wise to examine the U.S. history first.

Amidst the siren calls of financial stability concerns, it is worth remembering that not all indicators show asset price froth and excesses. In fact, some show the opposite. Here are a four:

(1) The risk premium as measured by the BAA corporate yield minus 10-year treasury yield is still elevated.

(2) Compared to recent years, households are still holding a relatively high share of liquid assets in their portfolios.

(3) Broad measures of money assets that include both retail and institutional assets have only recently passed pre-crisis peaks and are far below trend.

(4) The 10-year real risk-free treasury interest rate remains negative and closely tied to the output gap. This measure does not reflect the Fed's lowering of the term premium through QE, but of the expected path of the real economy. If the economy were frothy, we would expect it to be positive.